Beth lives in Atlanta, Cathy lives in Aberdeen, and Sarah lives in Amsterdam. They are sisters, and each earns around £40,000 a year. They also each pay roughly the same amount into a pension scheme. But, on retirement, Sarah in the Netherlands picks up a pension that is 50% higher than her sisters in Britain and the US. Why?

In a shocking new book Jon Lukomnik, the former head of New York’s $100bn city workers pension fund; David Pitt-Watson, the former director of a £50bn fund group in Britain; and Stephen Davis, who served on the US Securities and Exchange Commission and is now a senior fellow at Harvard, blow the whistle on how Anglo-American money management is failing the populations of both countries – and discuss what can be done to fix it.

Take, for example, Railpen – the pension scheme that covers 500,000 current and former railway workers in Britain. The workers have £21bn in the fund for their retirement, and were told that the costs of managing it were around £75m, mostly paid to external fund managers in the City. “Then [Railpen] did a substantial exercise on the trading costs in the fund, what exactly it was invested in, who was being paid for what etc. It came out that the true cost in fees was £290m,” says Pitt-Watson. Much of the cash was going to multi-millionaire hedge fund managers who typically siphon off 2% of the fund in fees every year, plus take a large cut of any gains that it makes.

Astonished by how much was leaking out to the City in fees, Railpen demanded cuts to the charges. As a result it has now saved around £100m a year in fees, Pitt-Watson says.

The book, What They Do With Your Money, subtitled How the financial system fails us and how to fix it, highlights the seemingly innocuous 1.5% a year fee typically levied to manage money. Over a lifetime that 1.5% means the fund manager and advisers help themselves to 38% of your pension savings, much of it on pointless short-term positions and over-trading. And as the authors point out, 1.5% a year is just what’s disclosed – the real fees are often alarmingly higher.

Wall Street and the City have become grossly inefficient at serving the needs of long-term savers, whose cash makes up most of the money swirling around on trading room floors. “The finance industry is not designed efficiently to create wealth for others. It has become positively awesome at creating wealth for itself,” the book says.

Meanwhile, a landmark study by Thomas Philippon, professor of finance at New York University, has calculated the productivity of finance since the 1880s. His central finding is that despite extraordinary improvements in technology and computing driving down costs across a multitude of sectors, there has been no reduction of costs in finance. It takes 2% to “intermediate” the managing of money, a figure that has been pretty consistent over the years; “indeed, in the past 30 years, the cost of finance has actually risen,” Philippon says. “No matter how you cut the data, there has been no trend towards cheaper or better service. Compare that with other industries and the results are staggeringly poor.”

By paying chief executives in shares we have encouraged them to play the market rather than build great companies

In 1950 the income of the financial sector in the US was equal to 4% of GDP, but by 2010 it had doubled to 8%. Philippon drily observes how financing business today is more costly than it was in the 1880s. “The finance industry that sustained the expansion of railroads, steel and chemical industries seems to have been more efficient than the current finance industry.”

In the fund management industry there are few economies of scale. In the US the explicit charge (the costs you are told about) for the average fund was 77 cents for every $100 invested. So if you invest $10,000 the asset manager picks up $77. If the fund grows to $50,000 they get $385. At $1bn they pick up $7.7m. There are no incentives to cut fees even as the income balloons.

Morningstar, a fund tracking firm, reports that there are 53,000 investment funds now open to small investors. “A number that is very costly to maintain and makes no sense from the point of view of the consumer,” say the authors of WTDWYM.

But their book is not just about fees. It identifies how fund manager incentives are inextricably linked to short-termism among big companies, making savers not just worse off but also starving the wider economy of long-term funds. “As soon as [asset managers] realise a company is in trouble, rather than try to improve things, they simply sell the shares. They have little patience with company directors who work to strengthen long-term performance if that does not increase the stock price in the short term.”

Fund managers typically hold shares for less than one year, as they trade in and out of stocks. “That a holding period of a year is considered long-term suggests the magnitude of the problem. What great company can be built in a year?” the book asks. Renowned investor Warren Buffett has been quoted as saying that his favourite holding period “is for ever”.

The outcome is boardrooms where directors suffer from financial attention deficit hyperactivity disorder. One study found that senior corporate officials in the US won’t countenance a long-term investment if it affects even one quarter of reported profits. The underlying savers in pension funds are investing for 30 years, but the managers of the money are investing for just three months.

Thus the boards of companies are now paid to do the wrong thing, claim the book’s authors. The introduction of stock options to “align” the interests of boards with fund managers has simply led to an explosion in pay, not performance. Pay formulas linked to share prices which are swayed by high-frequency traders undermine directors, the very people who are supposed to provide oversight of companies.

The profusion of highly paid specialists in finance makes returns for investors worse, not better. Revered economist Adam Smith argued that specialisation was at the heart of improved productivity and lower costs, citing the example of a pin factory.

But the authors of WTDWYM argue: “The chain of specialists has reached a ‘reductio ad absurdum point’ where the people we entrust to act on our behalf have become so numerous that much, if not most, of their compensation comes from other agents, rather than from us directly.” When you put your savings into a pension, a chain of up to 16 different “professionals” have to be paid, including your company pension staff who keep records of your deductions from pay, the fund “platform”, the fund manager, third party research firms, the broker who executes a stock trade, the stock exchange itself, the individual settling the trade, the custodians of the fund and so on. “Each step along the way makes perfect sense, but there are a lot of steps … and at each step there are numerous opportunities for agents to extract fees, often without our being aware of it.”

Smith, the founder of free market economics, actually suspected this might happen. If you give your money to other people to manage, “negligence and profusion” will prevail, he warned.

As the authors of WTDWYM say: “The financial sector has turned inwards, away from the real economy and toward growing the financial sector itself.” So what can be done to tame the beast? More regulation is not the answer, they claim. Instead they argue for governance reforms, new fiduciary duties, transparency, and for company bosses to be paid in cash, not huge bonuses related to short-term share performance.

“By paying chief executives primarily in shares we have encouraged them to play the market rather than build great companies,” the book says. “Deciding to pay CEOs in cash would allow directors to direct, while it would remove the myopic focus on stock price.” They are withering about remuneration committees that approve bumper pay and share packages when there is no evidence that they improve long-term performance. “You couldn’t design an incentive scheme better suited to keeping a CEO focused strictly on the short term if you tried.”

Fund managers should also be remunerated on time scales that match pension investors – over decades rather than months. They also demand a new ‘fidicuiary responsibility’ on asset managers and advisers, giving them a professional obligation to savers and forcing them to keep costs reasonable and visible.

The authors also talk extensively about corporate governance, but what they mean is reconnecting savers with the fact that, through these funds, they own most of the world’s companies.

More immediately, savers may want to use cheap index funds rather than pricey funds stuffed with charges. Pitt-Watson admits that for his own savings he has put nearly the whole lot in low-cost index tracker funds.

The authors have won support from some of the biggest names in British business, chief executives evidently exhausted with the punitive round of quarterly profit reporting. Sir Mark Moody-Stuart, former chairman of Royal Dutch Shell, one of the most widely held shares in pension funds, says: “This book exposes the multiple leakages to various agents operating between savers and pensioners and the companies they are invested in, as well as the problems of collective industry failure.”

But it is the earliest pioneers of pension investing that the authors believe should be our guide to the future. Two Scottish clergymen, Robert Wallace and Alexander Webster, launched the world’s first pension fund in 1743 for the benefit of dependents and widows. They were clerics who offered their service in good faith and absolute integrity. “If we could manage successfully to run such a pension in the 18th century, it should surely be possible in the 21st.”

•What They Do With Your Money by Stephen Davis, Jon Lukomnik and David Pitt-Watson (Yale University Press, £20). To order a copy for £20, go to bookshop.theguardian.com or call 0330 333 6846. Free UK P&P over £10 for online orders. Phone orders have min P&P of £1.99.